Financial market basics

Author: Steven posted in Investing basics tagged with Investing 101

Financial markets allow our economy to function as they move funds from savers (suppliers of extra funds) to the spenders (fund users). These fund transfers can occur directly through the buying/selling of securities (such as stock and bonds), or indirectly through financial institutions (for example a bank obtaining funds from the savers through a savings deposit and lending money to a corporation or buying a corporation’s bonds). This movement of funds is represented in the picture below.
financial system
Without financial markets, there wouldn’t be an investment opportunity allowing you potential to earn extra income (by taking extra risk) with your savings. For example, let’s say Jack the inventor has developed a prototype of a new robot that would greatly reduce the production cost in car manufacturing plants. In order for Jack to bring his product to market, he needs to raise cash. On the other side, you were able to save $5000 in a year and would like to earn some extra income on your savings. Financial markets facilitate this transfer by putting you in contact with Jack. If it weren’t for the financial market, Jack would be stuck with a great business idea but without the necessary money to bring it to market, and you would be stuck with $5000 without the option of earning extra income because of the lack of an attractive investment opportunity. People saving money are not always the same of those who have a profitable investment opportunity, thus financial markets play a key role in the global economy in order to optimize the transfer funds from savers to users of capital (known as capital allocation).

In the US, the main financial market is the securities market, which includes the stock market, the bond market and the options market, with financial institutions playing a key role in bringing the buyers and sellers together. Although each of these markets has its own distinctive features and characteristics, it is the force of supply and demand which define the instruments’ market price at any given point in time.

When we talk about a financial market, we need to distinguish between a primary market and a secondary market. A primary market is where new issues of stocks and bonds are sold by corporations and government agencies for the first time, while the secondary market deals with the buying a selling of securities which have already been introduced through the primary market. Some examples of secondary markets include the stocks traded in the S&P 500 Index, the NASDAQ market and the Dow Jones Industrial Average.

When a corporation needs to raise money in the securities market, they can do it either through debt (issuing bonds) or through equity (issuing common stock). As a bond investor, you are paid regular interest payments (usually every three months) from the issuing corporation until a specified date, known as the maturity date, when you receive your principal back. On the other hand, when you purchase stock in a corporation, you become a partial owner in the company and thus benefit from any dividends the company may decide to pay to the stockholders and in any price appreciation of the stock based on the success of the company.

When a corporation initially sells stocks or bonds through the primary market, they receive the funds from this transaction (minus any expenses charged by the financial institution that helped them sell the initial offering). When stocks and bonds are sold on the secondary market the company does not receive any additional funds from these transactions, these transactions are directly between the buyer and seller with a broker who executes the transaction. The secondary market is still important for a corporation because when it issues additional bonds or stock shares because the selling price in the primary market will be determined by the price in the secondary market. Consequently, the higher the price in the secondary market, the more money the company will raise in the primary market.

Financial markets can also be categorized based on the maturity of vehicles traded within the market. A financial market comprised only by short­term debt (with a maturity of less than 1 year), is known as the money market. On the other hand, a financial market comprised by longer term debt (greater than one year) and equity instruments is known as the capital market.

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